A meeting of senior managers at the Pringly Division has been called to discuss the pricing strategy for a new product. Part of the discussion will focus on estimating sales for the new product. Over the past years, a number of new products have failed to meet their sales targets. It appears that the company’s profit for the year will be lower than budget and the main reason for this is the disappointing sales of new products.
A new technique for estimating the probability of achieving target sales and profits will be discussed. This requires managers to estimate demand for the new product and assign probabilities. A range, rather than only one goal will be established.
The first strategy is to set a selling price of $170 with annual fixed costs at $20,000,000. A number of managers are in favor of this strategy, as they believe it is important to reduce costs.
The second strategy is to increase spending on advertising and promotions and set a selling price of $200. With the higher selling price the annual fixed costs would increase to $25,000,000. The marketing department are adamant that increased emphasis on advertising and promotions is essential.
The following probability distributions have been agreed with the managers after consultation with all departments and is the same for both selling prices.
Estimated demand (units)
Estimated probability (units)
150,000
0.25
180,000
0.5
200,000
0.25
Additional information:
The estimate or variable cost per unit is $30.
The probability of the new product achieving break-even is very important. A profit greater than $4,000,000 is expected.
Required:
Compute break-even at each level.
Is the company likely to achieve its desired target profit of $4,000,000 or more? Support your discussion with financial analysis.
Should the company go ahead with the new product?
Would this type of analysis be useful to a large company with a wide range of products?
ROI (return on investment) and residual income are two other methods that can helpful for this type of decisions. Could they be applied in this situation? Support your answer with financial analysis.
HINT: Don't forget to use the variable costing approach for your analysis.
I know how to do break even point but don't know what to do with the estimated demands & probabilities.
To compute the break-even point at each level, you need to consider the selling price, variable costs, and fixed costs. Let's go step by step:
Step 1: Calculate the contribution margin per unit.
The contribution margin is the difference between the selling price per unit and the variable cost per unit. In this case, the variable cost per unit is given as $30.
Contribution Margin = Selling Price per Unit - Variable Cost per Unit
For example, with a selling price of $170:
Contribution Margin = $170 - $30 = $140
Step 2: Calculate the break-even point.
The break-even point is the level of sales where the company's total revenue equals its total costs (fixed costs plus variable costs).
Break-even Point (in units) = Fixed Costs / Contribution Margin
For example, with fixed costs of $20,000,000 and a contribution margin of $140:
Break-even Point = $20,000,000 / $140 = 142,857 units
Repeat this calculation for the second strategy with a selling price of $200 and fixed costs of $25,000,000.
Now let's move on to analyzing the company's likelihood of achieving the desired target profit and whether they should proceed with the new product:
To determine if the company is likely to achieve its desired target profit of $4,000,000 or more, you will need to calculate the net income at each level of estimated demand, using the formula:
Net Income = (Selling Price per Unit - Variable Cost per Unit) x Estimated Demand - Fixed Costs
Calculate the net income at each level of estimated demand (150,000, 180,000, 200,000) for both strategies, and check if any of the net incomes exceed $4,000,000.
Finally, determine whether the company should proceed with the new product by considering factors such as the probability distribution of estimated demand and the potential profitability based on the net income analysis.
Regarding whether this type of analysis would be useful for a large company with a wide range of products, it can provide valuable insights into the potential profitability of different products and strategies. By considering estimated demand and probabilities, the company can make more informed decisions about resource allocation and pricing.
As for ROI (return on investment) and residual income, these are additional financial analysis tools that can be used to evaluate the profitability and performance of the new product. However, specific calculations and data would be required to apply these methods, and it's beyond the scope of the given information.